How to play it: Prepping for higher Treasury yields

NEW YORK (Reuters) - Signs of a new era of higher bond yields may be afoot after fears of a second financial crisis sent Treasury yields to historic lows last autumn.

Yields for the benchmark 10-year Treasury note have jumped to about 2.3 percent from 1.9 percent over the last few weeks, and last month's broad selloff hit the entire Treasury yield curve.

Thirty-year bond yields in March rose to the highest since September, while two-year yields reached their highest peak since July. While still low, the rising yields signal that bond market investors are becoming increasingly comfortable that the U.S. economy is expanding.

It's a reversal of one of the most popular - and profitable - trades from last year. Investors who bought 10-year Treasuries in early 2011 saw gains of 20 percent, according to data from Morningstar. That rally now appears over: longer-duration bonds are down 5 percent in 2012.

Some analysts expect the upward push in yields to continue. Wells Fargo, for instance, expects the yield of the 10-year Treasury to hit 3.0 percent by the end of the year.

"No matter what you did last year (in the fixed income market), you did pretty well. But we think that people will need to be more active in their strategies than in the past," said George Rusnak, national director of fixed income at Wells Fargo.

It's an argument that is not shared by every big bond fund manager. BlackRock's Ewen Cameron Watt, for instance, said in an radio interview this week that he believes the yield of the 10-year Treasury will stay below 3.0 percent for the rest of the year.

Here are suggestions on ways income-oriented investors can play it if yields continue to rise.

LOOK BEYOND TREASURY DEBT

Rusnak, from Wells Fargo, suggests that investors look to reduce the duration of their fixed income holdings to buffer themselves should interest rates rise.

One area he recommends: floating-rate funds. These funds, which differ from traditional bonds because they contain adjustable-rate loans, typically offer a fixed yield on top of the benchmark London Interbank Offered Rate (Libor), which is the rate that banks can borrow from each other.

When the Libor rate rises, investors collect higher yields - making these bonds attractive when interest rates start ticking higher. Investors, of course, take on more risk when opting for bank loans as opposed to U.S. government debt. The average investment grade corporate bond yields 4.2 percent, compared with a 2.3 percent yield for 10-year Treasuries, according to Morningstar.

These floating rate funds currently offer better values than Treasury Inflation Protected Securities, or TIPS, which are trading near highs, Rusnak said. Floating rate funds typically yield about 2 percentage points more than a comparable Treasury note, he said.

Dan Norman, a co-manager of the $248 million ING Floating Rate fund (IFRAX), said that he is targeting senior secured loans that reset to the Libor rate every 60 or 90 days, in part because of the low Treasury yields. "Once rates start to move off of these lows they move more rapidly because they have been low for so long," he said. Targeting loans that reset often limits an investor's rate risk, he said.

Rusnak, from Wells Fargo, also recommends looking at traditional bonds issued by financial companies, which could see their earnings rise if interest rates move upward because they will be making more profits off of money market accounts and other interest rate spreads.

The tiny $10 million iShares Financials Sector Bond (MONY)is perhaps the most targeted approach for those who opt for a fund over individual issues. It yields 3.0 percent and costs 30 cents per $100 invested.

Frank Fantozzi, president of Planned Financial Services in Cleveland, Ohio, said that rising interest rates should make real estate investment trusts (REITS) a profitable trade.

"Housing will become less affordable when mortgage rates rise, which makes rental real estate attractive because there will be upward pressure on rents," he said.

Rents are already rising. The U.S. apartment vacancy rate fell in the first quarter to its lower level since 2001, according to real estate research firm Reis, while rents rose by the largest amount since the first quarter of 2008.

Both Equity Residential and UDR, which each have large apartment holdings, yield around 3.5 percent. The $176 million iShares FRST NARETI Residential REIT ETF (REZ) is another option. The fund, which costs 48 cents per $100 invested, yields 3 percent. Equity Residential and Public Storage are its top holdings. The fund is up 6.0 percent in 2012.

Preferred shares could work as well, said Ken Himmler, president of Integrated Asset Management in Los Angeles. These securities - a class of stocks that have some of the same protections as bonds - typically offer yields higher than common stocks.

The iShares S&P U.S. Preferred Stock Index ETF (PFF), for instance, concentrates 80 percent of its holdings in financial firms. Preferred shares from General Motors and Barclays Bank are among its top weightings. The $8.4 billion fund yields 6.0 percent and costs 48 cents per $100 invested.